The approval of perpetual futures contracts in the US may lead to unforeseen tax and regulatory complications for traders, should these contracts be ultimately classified as swaps rather than futures, CME Group Chairman and CEO Terry Duffy warned in a recent interview. This ambiguity surrounding the tax status of perpetual futures contracts has the potential to affect all US participants. Duffy's comments come at a time when CME is engaged in a legal dispute with the Commodity Futures Trading Commission (CFTC) over the regulatory body's approval of perpetual futures contracts in the US.
The outcome of this case could have a substantial impact on how the US approaches the rapidly expanding market of perpetual futures. A key consequence of this dispute is how the Internal Revenue Service (IRS) will ultimately tax these contracts. The core issue revolves around whether perpetual futures should be legally categorized as futures or swaps. Duffy argues that perpetual futures should be considered swaps due to the periodic funding payments exchanged between long and short positions, which, in his view, aligns with the statutory definition of a swap under US law.
Unlike traditional futures contracts, perpetual contracts do not expire and instead involve periodic funding payments to maintain the derivative's price close to the underlying asset's price. Duffy believes this recurring payment exchange meets the definition of a swap. The main concern with the current designation is that if perpetual contracts are deemed futures, many institutional traders may receive a blended tax treatment under Section 1256 of the US tax code, where gains and losses are generally treated as 60% long-term and 40% short-term capital gains. However, if these contracts are classified as swaps, they will be subject to 'ordinary' taxation.
Given the novelty of perpetual futures, the IRS has not provided specific guidance on their tax treatment. This lack of clarity could lead to uncertainty for market participants who have been treating perpetual futures as futures for tax purposes, potentially facing questions from the IRS about their tax filings.
Legal experts note that the issue is more complex, with the textual structure of perpetual futures resembling swaps but functioning economically like futures, posing a 'substance over form' question. The definition of swaps is broad, leaving considerable room for interpretation, especially regarding new financial products like perpetual futures. The outcome will depend on the court's interpretation, given the Supreme Court's 2024 Loper Bright decision, which reduced the deference given to agencies' interpretations of ambiguous statutes.
This could lead to a lengthy and complex litigation process, with potential tax implications that may require separate guidance from the IRS, which is not bound to adopt the CFTC's interpretations. Until there is greater clarity from regulators, tax authorities, or the courts, large institutions may face uncertainty over reporting trades involving perpetual futures, potentially leading to significant tax liabilities and reputational risks.